Deflation Isn't Always So Bad -- Just Ask Japan

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By William Pesek

Milton Friedman would be aghast at economist Nicholas Smith's take on Japan's deflation.

The Nobel laureate is probably best known for his argument that inflation is always and everywhere a monetary phenomenon. When too much money chases too few goods, prices surge. Japan, of course, is beset with the flipside of this dynamic. Too little cash chasing too many goods is thought to be at the root of an economic funk that's now entering a third decade. Japan is currently shrinking at a 0.6 percent pace year-over-year.

What if falling prices aren't such a bad thing? That's the gist of a new report by Smith, a Japan strategist at CLSA Asia-Pacific Markets Ltd. in Tokyo, titled, "Does Deflation Even Matter?"

Absolutely, say Japan's political and corporate establishments. To this crowd, if only Japan could gin up a little inflation, all would be sunny. What Japan Inc. ignores, though, is that deflation isn't the cause of its woes but a symptom. Consumers and businesses have no confidence in the future, and so prices grind lower.

Yet, to Smith, that's not the crisis investors believe it to be. Hasn't Japan proven that it can be a manageable occurrence, as others have in past? England, Smith says, had deflation of 0.4 percent a year for its entire Victorian Golden Age of the 1800s and flourished. The U.S. has experienced it for a third of its history. The technology sector has had it for its entire history.

Yes, deflation can be devastating; look no further than the Great Depression of the 1930s. It can slam financial assets, boost debt-servicing costs and undermine top-line corporate profits. It affects confidence and lowers government tax revenue. Many investors consider deflation a third-rail trend, and avoid any economy grappling with it.

In high-cost Japan, it can act like a stealth tax cut that's leaving households with greater spending power. It has shaken up corporate Japan is unpredictable ways, encouraging mergers, downsizing, the abandonment of some uncompetitive industries and even creating investment opportunities.

Smith's advice: Pile into companies that thrive on deflation. They include convenience stores like Seven & I Holdings Co., discount retailers like Don Quijote Co. and online shopping outfits like Rakuten Inc. As the Bank of Japan comes under pressure to add more liquidity to the economy, investors might consider the shares of brokers like Daiwa Securities Group Inc. and real estate developers like Mitsubishi Estate Co.

We can fret about falling prices all we want. It's more constructive, though, to consider that this economic predicament isn't without silver linings.

(William Pesek is a Bloomberg View columnist. Follow him on Twitter.)

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-0- Apr/13/2012 13:09 GMT